Chapter 16

----- Chapter 16 -----
Going Private and Leveraged
Buyouts
Introduction
• Going private — transformation of a public
corporation into a privately held firm
• Leverage buyout (LBO) — purchase of a
company by a small group of investors
using a high percentage of debt financing
– Investors are outside financial group or
managers or executives of company
– Management buyout (MBO) — leveraged
buyout performed mainly by managers or
executives of the company
– Results in significant increase of equity share
ownership by managers
– Turnaround in performance is usually
associated with formation of LBO
– Typical LBO operation
• Financial buyer purchases company using high
level of debt financing
• Financial buyer replaces top management
• New management makes operating
improvements
• Financial buyer makes public offering of improved
company at higher price than originally purchased
Characteristics of Leveraged
Buyouts
• Leverage buyout activity
– Reached peak during 1986-1989
– Largest LBO was RJR Nabisco in 1988 with
purchase price of $24.6 million
– Total purchase price of 20 largest LBOs
formed during 1983-1995 was $76.5 billion
• Buyout group may include incumbent
management and may be associated
with
– Buyout specialists, e.g., Kohlberg Kravis
Roberts & Co.
– Investment bankers
– Commercial bankers
• Management buyouts (MBOs)
– Investor group dominated by incumbent
management
– Segment acquired from parent company
• LBO transaction may be reversed with
future public offering
– Aim is to increase profitability of company
and thereby increase market value of firm
– Buyout group seeks to harvest gain within
three- to five-year period
Three Major Stages of
Leveraged Buyouts
• The 1980s
– Economic and financial environments
favorable to M&A activity and LBOs
– For 1986-1989,
• LBO activity reached peak
• LBOs accounted for 20.5% of total dollar value of
completed mergers
• Premiums paid were at highest levels — mean of
33.9% and median of 26.5%
• Price earning ratios paid — mean of 20.5
• Early 1990s
– LBOs declined from peak total of $65.7
billion in 1989 to $6.8 billion in 1991
– Decline due to
• Economic and legislative changes
• Unsound LBO transactions of late 1980s
– For 1990-1992,
• LBOs accounted for 6.8% of total dollar value of
completed mergers
• Sharp decline in relative premiums paid — mean
of 27.6% and median of 19.9%
• Sharp decline in price earning ratios paid —
mean of 14.6
• Post-1992
– LBOs reached $62.0 billion in 1999
– Revival of LBOs due to new developments in
nature of LBO transactions and market
participants
– For 1993-1998,
• LBOs accounted for 1.6% of total dollar value of
completed mergers
• Relative premiums paid for LBOs slightly below
1986-1989 levels — mean of 33.5% and median
of 24.2%
• Price earning ratios paid — mean of 23.8
LBOs in the 1980s
• Characteristics
– Debt financing
• Highly leveraged — up to 90% of purchase price
• Debt secured by assets of acquired firm or based
on expected future cash flows
• Paid off either from sale of assets or from future
cash flows generated by operations
– Acquired company became privately held
– Firm expected to go public again after three
to five years
• General economic and financial factors
– Same as factors stimulating mergers
– Sometimes LBOs and MBOs were responses
to threat of unwanted takeovers
– Sustained economic growth between 1982-
1990
– Earlier inflation
• GNP implicit price deflator during 1968-1982 increased
by no less than 5%
• Caused q-ratio to decline sharply — cheaper to buy
capacity in financial markets than in real asset markets
• Provided opportunities to realize tax savings through
recapitalization
– Financing innovations — high-yield bonds
(junk bonds) made public financing available
to companies below investment grade
– Legislative factors, especially taxes
• Succession of laws that deregulated financial
institutions
• Economic Recovery Tax Act (ERTA) of 1981
• General Utilities doctrine
• Legislative changes affecting ESOPs —
encouraged MBOs
– Change in antitrust climate - beginning in
1980
• Elements of a typical LBO operation
– First stage — raise cash required for buyout
and devise management incentive systems
• Financing
– About 10% of cash is put up by investor group headed
by company's top managers and/or buyout specialist
– About 50-60% of required cash through secured bank
loans
– Rest of cash by issuing senior and junior subordinated
debt
» Private placement with pension funds, insurance
companies, venture capital firms
» Public offerings of "high-yield" notes or bonds (junk
bonds)
• Management incentives
– Managers receive stock price-based incentive
compensation in form of stock options or warrants
– Incentive compensation plans based on measures
such as operating performance
– Second stage — organizing sponsor group
takes company private
• Stock-purchase — buys all outstanding shares of
company
• Asset-purchase — purchases all assets of
company and forms new privately held
corporation
• New owners sell off parts of acquired firm to
reduce debt
– Third stage — management strives to
increase profits and cash flows
• Cut operating costs
• Cut spending in research and development
• Cut new plants and equipment as long as
provisions for capital expenditures are adequate
and satisfy lenders
• Increase revenues by changing marketing
strategies
– Fourth stage — reverse LBOs
• Investor group may take improved company
public again through public equity offering
(secondary initial public offering - SIPO)
• Create liquidity for existing stockholders
• Muscarella and Vetsuypens (1990)
– 72 reverse LBOs in 1976-1987
– 86% of firms use offering proceeds to lower company's
leverage
– Equity participants realized median annualized rate of
return of 268.4% on equity investment by time of SIPO
– Median length of time between LBO and SIPO was 29
months
• Conditions and circumstances of going-
private buyouts in the 1980s
– Typical target industries
• Basic, nonregulated industries
– Predictable and/or low financing requirements
– Predictable/stable earnings
• High-tech industry less appropriate
– Shorter history of profitability
– Greater business risk
– Fewer leveragable assets
– Command high P/E multiples well above book value
• Lehn and Poulsen (1988)
– Half of 108 LBOs during 1980-1984 were in five
industries:
» Retailing
» Textiles
» Food processing
» Apparel
» Soft drinks
– Consumer nondurable goods
» Low income elasticity of demand
» Sales fluctuate less with GNP
– Mature industry with limited growth opportunities
– Other target characteristics
• Track record of capable management
• Strong market position within industry to enable
it to withstand economic fluctuations and
competition
• Highly liquid balance sheet
– Little debt, either short or long term
– Large unencumbered asset base — for collateral
– High proportion of tangible assets with fair market
value above net book value
– Leverage factors
• Increase return on equity (ROE) and cash flows
to retire debt
• Attractions for lenders
– Interest rates only 3-5 points above prime rate
– Company and collateral characteristics
» Large amounts of cash/cash equivalents
» Undervalued assets (hidden equity)
» Could liquidate some subsidiaries to raise funds
– High prospective rates of return on equity especially for
lenders such as venture capitalists and insurance
companies with equity participation
– Confidence in management group spearheading LBO
– Management factors
• Record of capability
• Betting reputation and personal wealth on
success of LBO
• Highly motivated by potential large personal
gains from stock ownership
– Sources of MBO targets
• Divestitures of divisions by public companies
• Private companies with low growth records
• Public corporations selling at low P/E multiples
representing large discounts from book values
• Empirical results
– DeAngelo, DeAngelo, and Rice (1984)
• 72 firms making 72 initial and 9 subsequent
going-private proposals during 1973-1980
• Relatively small firms measured by median
market value of total equity
– $6 million for 45 pure going-private sample
– $15 million for 23 LBOs
• Pre-offer management ownership high
– Mean of 45% and median of 51% for 72 going-private
sample
– Mean of 32% and median of 33% for 23 LBOs
• Stockholder wealth effects
– At announcement: +22%, significant
– CAR for window [-40,0]: over +30%
– Measured as average premium over market (two months
before proposal): Over +56% for 57 cash payment
proposals
• Withdrawal of going-private announcements (18
firms)
– Negative return at announcement: -9%
– Offset by positive 13% return (Days -40 through 0) for net
effect of +4%
– Cumulative effect rises to +8% (Days 0 through +40)
– Explanations for positive impact of withdrawal:
» Information effect — permanent upward revaluation of firm's
prospects
» Probability that management might revive proposal
» Possibility that another acquirer might step in to make offer
– Lowenstein (1985)
• 28 MBOs during 1979-1984
• Each valued at over $100 million at winning bid
• Management ownership fraction very small
– Pre-offer: 3.8% (median); 6.5% (mean)
– Post-offer: 10.4% (median); 24.3% (mean)
• Premium over market price 30 days before
announcement:
– 58% (median); 56% (mean)
– Premiums rose with number of bids — three or more
bids, premium = 76% (median), 69% (mean)
– Premium over management bid in 11 successful third-
party bids relatively small — 8% (median), 14%
(mean)
– Lehn and Poulsen (1988)
• Sample of LBOs in 1980-1984
• Substantial leverage increases in 58 firms
– Average pre-LBO debt/equity ratio of 46%
– Average post-LBO debt/equity ratio of 552%
• Wealth effect for 92 LBOs (Days -20 through
+20) = over +20%, significant
• Average premium (relative to stock price 20
days before announcement) = 41% for 72 all
cash-offer LBOs
– Hite and Vetsuypens (1989)
• 151 divisional MBOs
• Small but significant wealth gain to parent
company shareholders
– Mean abnormal return during two-day period
surrounding announcement = 0.55%
– Abnormal return translates into 3.3% for full LBO (mean
sale price of division about 16.6% of market value of
average seller)
– Gains lower than those found for LBOs
• Interpretation
– Divisional MBOs reallocate ownership of corporate
assets to higher-valued uses
– Parent company shareholders share in expected
benefits of change in ownership structure
– Muscarella and Vetsuypens (1990)
• 45 divisional buyouts which subsequently went
public
• Average period from buyout to public offering
was 34 months
• Mean abnormal return of 1.98% to seller in two
days around announcement
• Sources of gains in LBOs during the 1980s
– Tax benefits — can enhance already viable
transaction
• Specific tax benefits
– Interest tax shelter from high leverage
– Asset step-up provides higher asset value for
depreciation expenses; especially accelerated
depreciation on assets involving little recapture — more
difficult under Tax Reform Act of 1986
– Tax advantages of using ESOP as LBO vehicle
• Lowenstein (1985)
– Most of premium paid is financed from tax savings
– New companies may operate tax-free up to six years
(LBO often sold at this point anyway when debt/equity
ratio declines from 10 times to 1 or under)
• Kaplan (1989a,b)
– Value of tax benefits
» At a 46% tax rate and permanent new debt, median
value of tax benefit at 1.297 times premium
» 30% tax rate and new debt with maturity of eight
years, median value of tax benefits at 0.262 times
premium
» For firms that used step-up basis of their assets —
median value of tax benefit at 0.304 times premium
– Large and predictable tax benefits
» Small portion attributed to unused debt capacity or
inefficient use of tax benefits prior to buyout
» Implies that large portion of tax benefits attributable
to buyout
– Prebuyout S/H capture most of tax benefits
– ESOP loans infrequently used due to nontax costs
– Management incentives and agency cost
effects
• Argument for: Increased ownership stake
provides increased incentives for improved
performance
– Profitable investments that require disproportionate
effort of managers may only be undertaken if
managers are given disproportionate share of profits
– Concentrated ownership aligns managers and
shareholders' interest, reducing agency costs
– Debt from LBO commits cash flows to debt payment,
reducing agency costs of free cash flows
– Debt puts pressure on managers to improve firm
performance to avoid bankruptcy
• Arguments against:
– In DeAngelo et al. study, management already held
large stake before buyout
– Internal and external controls are sufficient to align
managers' interests to shareholders
• Empirical evidence consistent with
management incentive rationale
– Increased ownership share of management
– Management incentive plans
– Operating performance of LBO firms improved
– Wealth transfer effects
• Payment of premiums in LBO transactions may
represent wealth transfer to shareholders from
other stakeholders
• Wealth transfer from existing bondholders and
preferred stockholders
– Reduction in value of firm's outstanding bonds and
preferred stock due to
» Large increase in debt
» Bond covenants may not protect existing
bondholders in event of control changes and debt
issue
» In bankruptcy proceedings, "absolute priority rule"
for senior security may not be strictly followed
– Lehn and Poulsen (1988) — no evidence that
bondholders and preferred stockholders lose value at
time of LBO announcement
– Travlos and Cornett (1993)
» Significant bondholder losses at announcement
of going-private proposals
» Losses small relative to gains to prebuyout
shareholders
– Anecdotal evidence
» Lawsuit filed against RJR Nabisco by large
bondholders
» Charged that $5 billion in highly rated bonds lost
nearly 20% in market value
– Warga and Welch (1993)
» Empirical results greatly influenced by source of
bond price data
» Use trader-quoted data from major investment
bank as opposed to exchange-base data
» Properly aggregated returns among correlated
bonds using S&P data source find no significant
loss to bondholder wealth
» Using trader-quoted data, there is a risk-adjusted
bondholder loss of 6%; but losses account for a
very small percentage of shareholder gains
• Wealth transfer from current employees to new
investors
– Management turnover in buyout firms lower than in
average firm; sometimes new management team is
brought in after LBO
– Number of employees grows more slowly in LBO firm
than others in same industry and sometimes even
decreases — may result from postbuyout divestitures
and more efficient use of labor
• Tax benefits in LBO constitute subsidy from
public and loss of revenue to government
– Premia paid in LBOs positively related to potential tax
benefits
– Net effect of LBO on government tax revenues may be
positive
» Shareholders pay capital gains taxes on sale of
their stock in LBO tender offer
» LBO investor group pays capital gains taxes when
firm goes public at a later date
» Improved profitability — firms pay more corporate
taxes
– Many of tax benefits from increased leverage could be
realized without LBOs
– Asymmetric information and underpricing
• Managers or investor groups have more
information on value of firm than public
shareholders
• Large premium in buyout proposal signals that
future operating income will be larger than
previously expected or firm is less risky than
previously perceived
• Investor group believes new company worth more
than purchase price — prebuyout shareholders
receive less than adequately informed
shareholders
• Kaplan (1991) — informed persons (managers
and directors) do not participate in buyout even
though they typically hold large stakes (median
share of 10% compared to 4.67% held by
management participants)
• Smith (1990)
– MBO proposals that fail due to board/stockholder
rejection, withdrawal, or higher outside bid are not
followed by increase in operating returns
– Indirect evidence that asymmetric information cannot
explain improved performance of bought-out firms
– Other efficiency considerations
• More efficient decision process as private firm
– No need to justify new programs with detailed studies
and reports to board of directors, more speedy actions
can be taken
– Public firms have to publish reports that can disclose
valuable information to competitors
• Stockholders' servicing costs and other related
expenses do not appear to be a major factor in
going private
• Alternatively, perhaps LBOs performed well
because of favorable stock market/economic
conditions
• Evidence on postbuyout equity values
– Muscarella and Vetsuypens (1990)
• Median change in firm value for 41 reverse LBOs was
89% for entire period between LBO and subsequent
SIPO — mean rate was 169.7%
• Median annualized rate of return was 36.6%
• Total shareholder wealth change positive and
significantly correlated with fraction of shares owned
by officers and directors
• Correlation between size-adjusted measure of salary
and shareholder wealth positive and significant
• Change in equity values were associated with
improvement in accounting measures of performance
– Kaplan (1991)
• For 21 buyouts, median excess return to
postbuyout investors (both debt and equity) is
26.1% above return on S&P 500
• Excess return close to premium earned by
prebuyout shareholders
• Excess return to postbuyout investors
significantly related to change in operating
income, not to potential tax benefits
• Prebuyout shareholders capture most of tax
benefits that become publicly known at time of
LBO
– Degeorge and Zeckhauser (1993)
• Reverse LBO experienced industry adjusted rise in
operating performance of 6.9% during year before
SIPO
• Same firms experience industry-adjusted decline in
operating performance of 2.59% in year following
SIPO
• Reason: Information asymmetries and pure
selection
– Managers take firm public only during exceptional years
– Managers have incentive to improve current performance
at expense of future profitability
– Purchasers look at strength of current performance and
future growth — only strong companies had ability to go
public and experience normal mean reversion following
SIPO
– Mian and Rosenfeld (1993)
• 85 reverse LBOs during 1983-1989
• Significant positive CAR measured for three-year
period beginning one day after SIPO
• CARs using Comparable Firm Index for first three
years was 4.65%, 21.96%, and 21.05%
• 39% of sample firms taken over within three years
after SIPO
• Most takeovers during second year
• Firms taken over outperformed comparable
investments over 100%
• Sample not taken over, CAR nearly zero
• 79% of acquired firms had gone public with an active
investor — reflects desire of main investor to liquidate
ownership
– Holthausen and Larcker (1996)
• 90 reverse LBOs during 1983-1988
• Firms outperformed their industries for four years
following reverse LBO
• Firm increased capital expenditure subsequent to
offering — firms were cash constrained while
under LBO but reduced leverage after SIPO
facilitated efficient investments
• Working capital increased after offering
• Firm performance decreased with declines in
level of equity ownership by management and
other insiders
• No evidence that performance after SIPO
related to changes in leverage
• Firms still public three years after SIPO
experienced median decline in ownership by
management insiders of 15% and by
nonmanagement insiders of 20%
• Board structure moved toward standard
patterns of non-LBO firms after SIPO
Correction Period 1991-1992
• Background
– LBO activity in 1991 dropped to $6.8 billion,
l0.4% of $65.7 billion in 1989
– Opler (1992) — LBOs in 1985-1989 period
had operating improvements comparable to
those in earlier period
– Kaplan and Stein (1993)
• LBOs formed in latter half of 1980s did not
perform as well
• Many experienced financial distress
• Deteriorating quality of LBOs in second
half of 1980s
– Relatively high prices paid
• Dollar volume of funds available exceeded
number of good prospects
• Multiples of price to expected cash flows rose
sharply
• Extreme winner's curse — substantial difference
between winning price and next highest bid
– Weakened financial structure
• Deal promoters required more cash up front,
weakening structure and incentives of later LBOs
• Public high-yield debt substituted for both private
subordinated debt and "strip" financing —
raised costs of reorganizing
• Commercial banks took smaller positions;
reduced commitments, shortened maturities,
required accelerated principal repayments
• Coverage of debt service requirements declined
— less than 1 in some cases
• Asset sales and immediate improvement of
profitability margins were required to cover
interest and other financial outlays in first year of
the LBO
• High-yield bonds with either zero-coupons or
interest payments consisting of more of same
securities (payment-in-kind) were utilized
• Cash requirements for debt service were
postponed for several years
– Legislative and regulatory changes —
FIRREA
• Required S&Ls to liquidate high-yield bonds
from portfolio holdings and prohibited further
investment in high-yield bonds
• Prices of high-yield debt were impacted
downward
– Economic downturn of 1990-1991
Role of Junk Bonds
• Junk bonds are high-yield bonds either
rated below investment grade or unrated
– S&P ratings: rated below BBB
– Moody's ratings: rated below Baa3
• Characteristics
– Size of market
• Between 1970 and 1977, junk bonds represented
3-4% of total public straight debt bonds
– Prior to 1977, high-yield bonds were "fallen angels,”
investment grade bonds whose ratings had been
subsequently lowered
– First issuer of bonds rated below investment grade was
Lehman Brothers in 1977
• By 1985 share had risen to 14.4% of total public
straight debt bonds
– Drexel Burnham Lambert became industry leader in
junk bond issues
– Drexel had 45% of market in 1986 and 43.2% through
November 1987
• Share of yearly new public bond issues had risen
from 1.1% in 1977 to almost 20% by 1985
• FIRREA, enacted in 1989, caused temporary
losses but by 1993 junk bond market achieved
record high returns and size of market reached
new highs
– Default rates 10 years after issuance as high
as 20-30%
– Average recovery rate after default about 40%
of original par value
– Promised yield spread over 10-year Treasury
bonds about 4.5% during 1978-1994
– Realized return spread about 2%
• Use of high-yield bonds
– Make financing available to high risk,
growth firms
– Finance takeovers
– Yago (1991)
• One-fourth of proceeds from issuing junk
bonds in 1980-1986 used for acquisition
financing
• Three-fourth of proceeds used to finance
internal corporate growth
• Savings and loan industry
– High-yield financing was not fundamental
cause of problems in S&L industry during the
1980s
– Total investment in junk bonds amounted to
1% or less of total assets in industry
– S&L basic problems due to
• Changing nature of financial markets
• S&L industry had negative net worth of over $100
billion by 1980, prior to era of high-yield financing
• 90% of firms in S&L industry suffered losses in
1980 and 1981
• Role of Michael Milken
– Saul (1993) set forth his views of illegal acts
by Milken
• Securities parking
– Violation of Williams Act
– Entails having associates hold securities in their
accounts to avoid triggering Rule 13(d) filing requirement
• Market stabilization
– Milken guaranteed investment participants against losses
on their high-yield bond investment during time required
for markets to absorb them
– He did not make public disclosure in high-yield offerings
of securities taken as underwriting compensation
– He made side payoffs to portfolio managers for investing
institutional funds in his issues
• Market monopolization — Milken became
dominant player of high-yield bond market
– Financial competitors did not have Milken's network to
be "highly confident" that it could successfully place a
high-yield offering
– No other firm was prepared to commit so much capital
to inventory high-yield bonds in secondary market
trading
– Milken developed close relationships with client
issuers, institutional customers, and employees
– Fischel (1995) presented a defense of
Milken
• Milken was guilty only of being a tough and
formidable competitor
• Milken was not guilty of breaking any security
law violations
• Action against Milken as result of
– Hysteria against "excesses of the 1980s"
– Ability of government to invoke RICO
• After most thorough investigations, government
came up with nothing
LBOs in the 1992-2000 Period
• Background
– 1992-2000: Sustained economic growth —
resurgence of LBOs
– Size of aggregate LBO transactions moved to
$62.0 billion in 1999 — almost as high as the
peak of $65.7 billion in 1989
• Resurgence of LBOs
– Favorable economic environment
– Change in LBO financial structure
• Price to EBITDA ratios paid moved down to 5-6
times compared to 7-10 multiples of late 1980s
• Percentage of equity in initial capital structure
moved up to 20-30% compared with equity ratios
of 5-10% in late 1980s
• Interest coverage ratios moved up — ratio of
EBITDA to interest and other financial
requirements moved to standard of 2 times
– Restructuring of intermediaries
• LBO activity no longer dominated by Milken-Drexel
• Main players were other investment banking
houses, large commercial banks, and traditional
LBO sponsors such as Kohlberg Kravis Roberts
– Innovative approaches developed by
investment banking-sponsoring firms
• Strategy of substituting sponsor equity for bank
debt
• Less pressure for immediate performance
improvement or asset sales — deals structured so
principal repayments sometimes not required until
10 years after deal
• Partnership structures with members who had
considerable previous managerial experience
• Joint deals between financial buyers and
corporate strategic buyers to purchase companies
on leveraged basis
• Increased use of syndication among banks to
sponsor highly leveraged transactions
• Development of highly liquid secondary loan
trading market
• Continuing close client-focused relationship by
commercial banks
• Capital structure strategies tailored to
characteristics of transactions
• Leveraged buildups
– Identify fragmented industry characterized by small
firms
– Buyout firms purchase firm as platform for further
leveraged acquisitions in same industry
– Buyout firms include partners with industry expertise
• LBOs applied beyond mature slow-growing
industries to high-growth technology-driven
industries